[Federal Register Volume 60, Number 151 (Monday, August 7, 1995)]
[Rules and Regulations]
[Pages 40086-40092]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-19285]



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DEPARTMENT OF THE TREASURY
26 CFR Part 301

[TD 8610]
RIN 1545-AP98


Taxable Mortgage Pools

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to taxable 
mortgage pools. This action is necessary because of changes made to the 
law by the Tax Reform Act of 1986. The final regulations provide 
guidance to entities for determining whether they are subject to the 
taxable mortgage pool rules.

EFFECTIVE DATE: These regulations are effective September 6, 1995.

FOR FURTHER INFORMATION CONTACT: Arnold P. Golub or Marshall D. 
Feiring, (202) 622-3950 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    A notice of proposed rulemaking (FI-55-91) under section 7701(i) of 
the Internal Revenue Code was published in the Federal Register on 
December 23, 1992 (57 FR 61029). Written comments relating to this 
notice were received, but no public hearing was requested or held. 
After consideration of the comments, the proposed regulations under 
section 7701(i) are adopted as revised by this Treasury decision.

Explanation of Provisions

Section 301.7701(i)-1(c)(1)--Basis Used To Determine the Composition of 
an Entity's Assets

    Among other requirements, to be classified as a taxable mortgage 
pool, substantially all of an entity's assets must consist of debt 
obligations, and more than 50 percent of those debt obligations must 
consist of real estate mortgages (or interests therein). Under the 
proposed regulations, an entity must apply these tests using the tax 
bases of its assets. One commentator, however, suggested that the 
entity should have the choice of using either the tax bases of its 
assets or the fair market value of its assets. The IRS and Treasury 
believe that using fair market value for the asset composition tests 
creates uncertainty and administrative difficulties. The final 
regulations, therefore, retain the rule in the proposed regulations.

Section 301.7701(i)-1(c)(5)--Seriously Impaired Real Estate Mortgages 
Not Treated as Debt Obligations

    Under the proposed regulations, real estate mortgages that are 
seriously impaired are not treated as debt obligations for purposes of 
the asset composition tests. Whether real estate mortgages are 
seriously impaired generally depends on all the facts and 
circumstances. The proposed regulations, however, provide two safe 
harbors. Under those provisions, whether mortgages are seriously 
impaired depends only on the number of days the payments on the 
mortgages are delinquent (more than 89 days for single family 
residential real estate mortgages and more than 59 days for multi-
family residential and commercial real estate mortgages). The safe 
harbors are not available, however, if an entity is receiving or 
anticipates receiving certain payments on the mortgages such as 
payments of principal and interest that are substantial and relatively 
certain as to amount.
    Several commentators have asked for additional safe harbors based 
on factors other than the number of days a mortgage is delinquent. For 
example, one suggested a safe harbor for mortgages having excessively 
high loan to value ratios. Others suggested a safe harbor for mortgages 
that are purchased at a substantial discount.
    The final regulations retain, unchanged, the safe harbors of the 
proposed regulations. The IRS and Treasury believe that no single 
factor is as clear an indication that a mortgage is seriously impaired 
as days delinquent. For example, a mortgage may be purchased at a 
discount for a variety of reasons, some of which bear no relation to 
the quality of the mortgage. To provide further guidance, however, the 
final regulations list some of the facts and circumstances that should 
be considered in determining whether a mortgage is seriously impaired.
    Another commentator has criticized the safe harbors because they 
are unavailable if an entity anticipates receiving certain payments on 
a delinquent mortgage. The commentator is concerned that a test based 
on whether an entity anticipates receiving payments on a mortgage is 
both subjective and open-ended. To address this concern, the final 
regulations create a new rule, under which if an entity makes 
reasonable efforts to resolve a 

[[Page 40087]]
mortgage and fails to do so within a designated time, then the entity 
is treated as not having anticipated receiving payments on the 
mortgage.

Section 301.7701(i)-1(d)(3)(ii)--Obligations Secured by Other 
Obligations Treated as Principally Secured by Real Property

    Under the proposed regulations, an obligation is treated as a real 
estate mortgage if it is principally secured by an interest in real 
property. Whether an obligation is principally secured by an interest 
in real property ordinarily depends on the value of the real property 
relative to the amount of the obligation. The proposed regulations also 
provide that an obligation secured by real estate mortgages is treated 
as an obligation secured by an interest in real property. That 
obligation, therefore, may itself qualify as a real estate mortgage.
    The final regulations retain these rules and clarify how they are 
applied if an obligation is secured by both real estate mortgages and 
other property. Under the final regulations, such an obligation is 
treated as secured by real property, but only to the extent of the 
combined value of the real estate mortgages and any real property that 
secures the obligation.

Section 301.7701(i)-1(f)(3)--Certain Liquidating Entities Not Treated 
as Taxable Mortgage Pools

    The proposed regulations provide that an entity formed to liquidate 
real estate mortgages is not treated as a taxable mortgage pool if the 
entity meets four conditions. One condition is that the entity must 
liquidate within three years of acquiring its first asset. If the 
entity fails to liquidate within that time, then the payments the 
entity receives on its assets must be paid through to the holders of 
the entity's liabilities in proportion to the adjusted issue prices of 
the liabilities.
    One commentator has asked that this condition be modified. The 
commentator suggested that either the three- year liquidation period 
should be extended to four years or an entity should have to liquidate 
only a certain percentage of its assets within the three-year period. 
The commentator alternatively suggested that an entity should be 
treated as meeting the condition if it satisfies fifty percent of the 
issue price of each of its liabilities using liquidation proceeds.
    The final regulations retain the three-year liquidation rule. The 
IRS and Treasury believe that performing mortgages that conform to 
current underwriting standards may easily be disposed of within that 
time. Further, the market has developed to the point where three years 
is also ample time to dispose of non-performing mortgages. Mortgages 
that require more than three years for disposal are more likely to be 
seriously impaired, and a taxpayer who holds a sufficient quantity can 
avoid taxable mortgage pool classification by other means. The final 
regulations, therefore, do not change the basic rules in the proposed 
regulations.

Section 301.7701-1(g)--Anti-Avoidance Rules

    An anti-avoidance rule in the proposed regulations authorizes the 
Commissioner to disregard or make other adjustments to any transaction 
if the transaction is entered into with a view to achieving the same 
economic effect as that of an arrangement subject to section 7701(i) 
while avoiding the application of that section. This authority is 
flexible, and among other things, includes the ability to override any 
safe harbor otherwise available under the regulations. The final 
regulations retain the anti-avoidance rule and provide two additional 
examples illustrating its exercise.

Section 301.7701(i)-4--Certain Governmental Entities Not Treated as 
Taxable Mortgage Pools

    The proposed regulations provide that an entity is not classified 
as a taxable mortgage pool if: (1) The entity issuing the debt 
obligations is a State, the District of Columbia, or a political 
subdivision within the meaning of Sec. 1.103-1(b), or is empowered to 
issue obligations on behalf of one of the foregoing; (2) the entity 
issues the debt obligations in the performance of a governmental 
purpose; and (3) the entity holds the remaining interest in any asset 
that supports the outstanding debt obligations until those obligations 
are satisfied.
    Two commentators have asked that the third requirement be dropped 
because it prevents a governmental entity from reselling a package of 
mortgages. The IRS and Treasury believe, however, that dropping the 
requirement is inappropriate. Typically, when a mortgage pool is used 
to create multiple class debt, tax gains in excess of economic gains 
are generated during the early part of the pool's life and tax losses 
in excess of economic losses are generated during the latter part of 
the pool's life. Without the third requirement, a governmental entity 
can hold an interest in the pool during the early period and then 
convey that interest to a taxable entity during the latter period. 
Moreover, requiring a governmental entity to maintain an interest in 
pool assets is consistent with the second requirement that debt 
obligations supported by the pool are issued in performance of a 
governmental purpose.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on its 
impact on small business.

Drafting Information

    The principal authors of these regulations are Marshall D. Feiring 
and Arnold P. Golub, Office of Assistant Chief Counsel (Financial 
Institutions and Products), and Carol E. Schultze, formerly of that 
office. However, other personnel from the IRS and Treasury Department 
participated in their development.
    The Office of Assistant Chief Counsel (Financial Institutions and 
Products) notes with sadness the passing of Susan E. Overlander, who 
contributed significantly to this project.

List of Subjects in 26 CFR Part 301

    Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income 
taxes, Penalties, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 301 is amended as follows:

PART 301--PROCEDURE AND ADMINISTRATION

    Paragraph 1. The authority citation for part 301 is amended by 
adding the following citations in numerical order to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 301.7701(i)-1(g)(1) also issued under 26 U.S.C. 
7701(i)(2)(D).
    Section 301.7701(i)-4(b) also issued under 26 U.S.C. 7701(i)(3). 
* * *

    Par. 2. Sections 301.7701(i)-0 through 301.7701(i)-4 are added to 
read as follows:

[[Page 40088]]



Sec. 301.7701(i)-0  Outline of taxable mortgage pool provisions.

    This section lists the major paragraphs contained in 
Secs. 301.7701(i)-1 through 301.7701(i)-4.

Sec. 301.7701(i)-1  Definition of a taxable mortgage pool.

    (a) Purpose.
    (b) In general.
    (c) Asset composition tests.
    (1) Determination of amount of assets.
    (2) Substantially all.
    (i) In general.
    (ii) Safe harbor.
    (3) Equity interests in pass-through arrangements.
    (4) Treatment of certain credit enhancement contracts.
    (i) In general.
    (ii) Credit enhancement contract defined.
    (5) Certain assets not treated as debt obligations.
    (i) In general.
    (ii) Safe harbor.
    (A) In general.
    (B) Payments with respect to a mortgage defined.
    (C) Entity treated as not anticipating payments.
    (d) Real estate mortgages or interests therein defined.
    (1) In general.
    (2) Interests in real property and real property defined.
    (i) In general.
    (ii) Manufactured housing.
    (3) Principally secured by an interest in real property.
    (i) Tests for determining whether an obligation is principally 
secured.
    (A) The 80 percent test.
    (B) Alternative test.
    (ii) Obligations secured by real estate mortgages (or interests 
therein), or by combinations of real estate mortgages (or interests 
therein) and other assets.
    (A) In general.
    (B) Example.
    (e) Two or more maturities.
    (1) In general.
    (2) Obligations that are allocated credit risk unequally.
    (3) Examples.
    (f) Relationship test.
    (1) In general.
    (2) Payments on asset obligations defined.
    (3) Safe harbor for entities formed to liquidate assets.
    (g) Anti-avoidance rules.
    (1) In general.
    (2) Certain investment trusts.
    (3) Examples.

Sec. 301.7701(i)-2  Special rules for portions of entities.

    (a) Portion defined.
    (b) Certain assets and rights to assets disregarded.
    (1) Credit enhancement assets.
    (2) Assets unlikely to service obligations.
    (3) Recourse.
    (c) Portion as obligor.
    (1) In general.
    (2) Example.

Sec. 301.7701(i)-3  Effective dates and duration of taxable 
mortgage pool classification.

    (a) Effective dates.
    (b) Entities in existence on December 31, 1991.
    (1) In general.
    (2) Special rule for certain transfers.
    (3) Related debt obligation.
    (4) Example.
    (c) Duration of taxable mortgage pool classification.
    (1) Commencement and duration.
    (2) Testing day defined.

Sec. 301.7701(i)-4  Special rules for certain entities.

    (a) States and municipalities.
    (1) In general.
    (2) Governmental purpose.
    (3) Determinations by the Commissioner.
    (b) REITs. [Reserved]
    (c) Subchapter S corporations.
    (1) In general.
    (2) Portion of an S corporation treated as a separate 
corporation.


Sec. 301.7701(i)-1  Definition of a taxable mortgage pool.

    (a) Purpose. This section provides rules for applying section 
7701(i), which defines taxable mortgage pools. The purpose of section 
7701(i) is to prevent income generated by a pool of real estate 
mortgages from escaping Federal income taxation when the pool is used 
to issue multiple class mortgage-backed securities. The regulations in 
this section and in Secs. 301.7701(i)-2 through 301.7701(i)-4 are to be 
applied in accordance with this purpose. The taxable mortgage pool 
provisions apply to entities or portions of entities that qualify for 
REMIC status but do not elect to be taxed as REMICs as well as to 
certain entities or portions of entities that do not qualify for REMIC 
status.
    (b) In general.  (1) A taxable mortgage pool is any entity or 
portion of an entity (as defined in Sec. 301.7701(i)-2) that satisfies 
the requirements of section 7701(i)(2)(A) and this section as of any 
testing day (as defined in Sec. 301.7701(i)-3(c)(2)). An entity or 
portion of an entity satisfies the requirements of section 
7701(i)(2)(A) and this section if substantially all of its assets are 
debt obligations, more than 50 percent of those debt obligations are 
real estate mortgages, the entity is the obligor under debt obligations 
with two or more maturities, and payments on the debt obligations under 
which the entity is obligor bear a relationship to payments on the debt 
obligations that the entity holds as assets.
    (2) Paragraph (c) of this section provides the tests for 
determining whether substantially all of an entity's assets are debt 
obligations and for determining whether more than 50 percent of its 
debt obligations are real estate mortgages. Paragraph (d) of this 
section defines real estate mortgages for purposes of the 50 percent 
test. Paragraph (e) of this section defines two or more maturities and 
paragraph (f) of this section provides rules for determining whether 
debt obligations bear a relationship to the assets held by an entity. 
Paragraph (g) of this section provides anti-avoidance rules. Section 
301.7701(i)-2 provides rules for applying section 7701(i) to portions 
of entities and Sec. 301.7701(i)-3 provides effective dates. Section 
301.7701(i)-4 provides special rules for certain entities. For purposes 
of the regulations under section 7701(i), the term entity includes a 
portion of an entity (within the meaning of section 7701(i)(2)(B)), 
unless the context clearly indicates otherwise.
    (c) Asset composition tests--(1) Determination of amount of assets. 
An entity must use the Federal income tax basis of an asset for 
purposes of determining whether substantially all of its assets consist 
of debt obligations (or interests therein) and whether more than 50 
percent of those debt obligations (or interests) consist of real estate 
mortgages (or interests therein). For purposes of this paragraph, an 
entity determines the basis of an asset with the assumption that the 
entity is not a taxable mortgage pool.
    (2) Substantially all--(i) In general. Whether substantially all of 
the assets of an entity consist of debt obligations (or interests 
therein) is based on all the facts and circumstances.
    (ii) Safe harbor. Notwithstanding paragraph (c)(2)(i) of this 
section, if less than 80 percent of the assets of an entity consist of 
debt obligations (or interests therein), then less than substantially 
all of the assets of the entity consist of debt obligations (or 
interests therein).
    (3) Equity interests in pass-through arrangements. The equity 
interest of an entity in a partnership, S corporation, trust, REIT, or 
other pass-through arrangement is deemed to have the same composition 
as the entity's share of the assets of the pass-through arrangement. 
For example, if an entity's stock interest in a REIT has an adjusted 
basis of $20,000, and the assets of the REIT consist of equal portions 
of real estate mortgages and other real estate assets, then the entity 
is treated as holding $10,000 of real estate mortgages and $10,000 of 
other real estate assets.
    (4) Treatment of certain credit enhancement contracts--(i) In 
general. A credit enhancement contract (as defined in paragraph 
(c)(4)(ii) of this section) is not treated as a separate asset of an 
entity for purposes of the asset composition tests set forth in section 


[[Page 40089]]
7701(i)(2)(A)(i), but instead is treated as part of the asset to which 
it relates. Furthermore, any collateral supporting a credit enhancement 
contract is not treated as an asset of an entity solely because it 
supports the guarantee represented by that contract.
    (ii) Credit enhancement contract defined. For purposes of this 
section, a credit enhancement contract is any arrangement whereby a 
person agrees to guarantee full or partial payment of the principal or 
interest payable on a debt obligation (or interest therein) or on a 
pool of such obligations (or interests), or full or partial payment on 
one or more classes of debt obligations under which an entity is the 
obligor, in the event of defaults or delinquencies on debt obligations, 
unanticipated losses or expenses incurred by the entity, or lower than 
expected returns on investments. Types of credit enhancement contracts 
may include, but are not limited to, pool insurance contracts, 
certificate guarantee insurance contracts, letters of credit, 
guarantees, or agreements whereby an entity, a mortgage servicer, or 
other third party agrees to make advances (regardless of whether, under 
the terms of the agreement, the payor is obligated, or merely 
permitted, to make those advances). An agreement by a debt servicer to 
advance to an entity out of its own funds an amount to make up for 
delinquent payments on debt obligations is a credit enhancement 
contract. An agreement by a debt servicer to pay taxes and hazard 
insurance premiums on property securing a debt obligation, or other 
expenses incurred to protect an entity's security interests in the 
collateral in the event that the debtor fails to pay such taxes, 
insurance premium, or other expenses, is a credit enhancement contract.
    (5) Certain assets not treated as debt obligations--(i) In general. 
For purposes of section 7701(i)(2)(A), real estate mortgages that are 
seriously impaired are not treated as debt obligations. Whether a 
mortgage is seriously impaired is based on all the facts and 
circumstances including, but not limited to: the number of days 
delinquent, the loan-to-value ratio, the debt service coverage (based 
upon the operating income from the property), and the debtor's 
financial position and stake in the property. However, except as 
provided in paragraph (c)(5)(ii) of this section, no single factor in 
and of itself is determinative of whether a loan is seriously impaired.
    (ii) Safe harbor--(A) In general. Unless an entity is receiving or 
anticipates receiving payments with respect to a mortgage, a single 
family residential real estate mortgage is seriously impaired if 
payments on the mortgage are more than 89 days delinquent, and a multi-
family residential or commercial real estate mortgage is seriously 
impaired if payments on the mortgage are more than 59 days delinquent. 
Whether an entity anticipates receiving payments with respect to a 
mortgage is based on all the facts and circumstances.
    (B) Payments with respect to a mortgage defined. For purposes of 
paragraph (c)(5)(ii)(A) of this section, payments with respect to a 
mortgage mean any payments on the mortgage as defined in paragraph 
(f)(2)(i) of this section if those payments are substantial and 
relatively certain as to amount and any payments on the mortgage as 
defined in paragraph (f)(2) (ii) or (iii) of this section.
    (C) Entity treated as not anticipating payments. With respect to 
any testing day (as defined in Sec. 301.7701(i)-3(c)(2)), an entity is 
treated as not having anticipated receiving payments on the mortgage as 
defined in paragraph (f)(2)(i) of this section if 180 days after the 
testing day, and despite making reasonable efforts to resolve the 
mortgage, the entity is not receiving such payments and has not entered 
into any agreement to receive such payments.
    (d) Real estate mortgages or interests therein defined--(1) In 
general. For purposes of section 7701(i)(2)(A)(i), the term real estate 
mortgages (or interests therein) includes all--
    (i) Obligations (including participations or certificates of 
beneficial ownership therein) that are principally secured by an 
interest in real property (as defined in paragraph (d)(3) of this 
section);
    (ii) Regular and residual interests in a REMIC; and
    (iii) Stripped bonds and stripped coupons (as defined in section 
1286(e) (2) and (3)) if the bonds (as defined in section 1286(e)(1)) 
from which such stripped bonds or stripped coupons arose would have 
qualified as real estate mortgages or interests therein.
    (2) Interests in real property and real property defined--(i) In 
general. The definition of interests in real property set forth in 
Sec. 1.856-3(c) of this chapter and the definition of real property set 
forth in Sec. 1.856-3(d) of this chapter apply to define those terms 
for purposes of paragraph (d) of this section.
    (ii) Manufactured housing. For purposes of this section, the 
definition of real property includes manufactured housing, provided the 
properties qualify as single family residences under section 25(e)(10) 
and without regard to the treatment of the properties under state law.
    (3) Principally secured by an interest in real property--(i) Tests 
for determining whether an obligation is principally secured. For 
purposes of paragraph (d)(1) of this section, an obligation is 
principally secured by an interest in real property only if it 
satisfies either the test set out in paragraph (d)(3)(i)(A) of this 
section or the test set out in paragraph (d)(3)(i)(B) of this section.
    (A) The 80 percent test. An obligation is principally secured by an 
interest in real property if the fair market value of the interest in 
real property (as defined in paragraph (d)(2) of this section) securing 
the obligation was at least equal to 80 percent of the adjusted issue 
price of the obligation at the time the obligation was originated (that 
is, the issue date). For purposes of this test, the fair market value 
of the real property interest is first reduced by the amount of any 
lien on the real property interest that is senior to the obligation 
being tested, and is reduced further by a proportionate amount of any 
lien that is in parity with the obligation being tested.
    (B) Alternative test. An obligation is principally secured by an 
interest in real property if substantially all of the proceeds of the 
obligation were used to acquire, improve, or protect an interest in 
real property that, at the origination date, is the only security for 
the obligation. For purposes of this test, loan guarantees made by 
Federal, state, local governments or agencies, or other third party 
credit enhancement, are not viewed as additional security for a loan. 
An obligation is not considered to be secured by property other than 
real property solely because the obligor is personally liable on the 
obligation.
    (ii) Obligations secured by real estate mortgages (or interests 
therein), or by combinations of real estate mortgages (or interests 
therein) and other assets--(A) In general. An obligation secured only 
by real estate mortgages (or interests therein), as defined in 
paragraph (d)(1) of this section, is treated as an obligation secured 
by an interest in real property to the extent of the value of the real 
estate mortgages (or interests therein). An obligation secured by both 
real estate mortgages (or interests therein) and other assets is 
treated as an obligation secured by an interest in real property to the 
extent of both the value of the real estate mortgages (or interests 
therein) and the value of so much of the other assets that constitute 
real property. Thus, under this paragraph, a collateralized mortgage 

[[Page 40090]]
obligation may be an obligation principally secured by an interest in 
real property. This section is applicable only to obligations issued 
after December 31, 1991.
    (B) Example. The following example illustrates the principles of 
this paragraph (d)(3)(ii):

    Example. At the time it is originated, an obligation has an 
adjusted issue price of $300,000 and is secured by a $70,000 loan 
principally secured by an interest in a single family home, a fifty 
percent co-ownership interest in a $400,000 parcel of land, and 
$80,000 of stock. Under paragraph (d)(3)(ii)(A) of this section, the 
obligation is treated as secured by interests in real property and 
under paragraph (d)(3)(i)(A) of this section, the obligation is 
treated as principally secured by interests in real property.

    (e) Two or more maturities--(1) In general. For purposes of section 
7701(i)(2)(A)(ii), debt obligations have two or more maturities if they 
have different stated maturities or if the holders of the obligations 
possess different rights concerning the acceleration of or delay in the 
maturities of the obligations.
    (2) Obligations that are allocated credit risk unequally. Debt 
obligations that are allocated credit risk unequally do not have, by 
that reason alone, two or more maturities. Credit risk is the risk that 
payments of principal or interest will be reduced or delayed because of 
a default on an asset that supports the debt obligations.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (e):

    Example 1. (i) Corporation M transfers a pool of real estate 
mortgages to a trustee in exchange for Class A bonds and a 
certificate representing the residual beneficial ownership of the 
pool. All Class A bonds have a stated maturity of March 1, 2002, but 
if cash flows from the real estate mortgages and investments are 
sufficient, the trustee may select one or more bonds at random and 
redeem them earlier.
    (ii) The Class A bonds do not have different maturities. Each 
outstanding Class A bond has an equal chance of being redeemed 
because the selection process is random. The holders of the Class A 
bonds, therefore, have identical rights concerning the maturities of 
their obligations.
    Example 2. (i) Corporation N transfers a pool of real estate 
mortgages to a trustee in exchange for Class C bonds, Class D bonds, 
and a certificate representing the residual beneficial ownership of 
the pool. The Class D bonds are subordinate to the Class C bonds so 
that cash flow shortfalls due to defaults or delinquencies on the 
real estate mortgages are borne first by the Class D bond holders. 
The terms of the bonds are otherwise identical in all relevant 
aspects except that the Class D bonds carry a higher coupon rate 
because of the subordination feature.
    (ii) The Class C bonds and the Class D bonds share credit risk 
unequally because of the subordination feature. However, neither 
this difference, nor the difference in interest rates, causes the 
bonds to have different maturities. The result is the same if, in 
addition to the other terms described in paragraph (i) of this 
Example 2, the Class C bonds are accelerated as a result of the 
issuer becoming unable to make payments on the Class C bonds as they 
become due.

    (f) Relationship test--(1) In general. For purposes of section 
7701(i)(2)(A)(iii), payments on debt obligations under which an entity 
is the obligor (liability obligations) bear a relationship to payments 
(as defined in paragraph (f)(2) of this section) on debt obligations an 
entity holds as assets (asset obligations) if under the terms of the 
liability obligations (or underlying arrangement) the timing and amount 
of payments on the liability obligations are in large part determined 
by the timing and amount of payments or projected payments on the asset 
obligations. For purposes of the relationship test, any payment 
arrangement, including a swap or other hedge, that achieves a 
substantially similar result is treated as satisfying the test. For 
example, any arrangement where the timing and amount of payments on 
liability obligations are determined by reference to a group of assets 
(or an index or other type of model) that has an expected payment 
experience similar to that of the asset obligations is treated as 
satisfying the relationship test.
    (2) Payments on asset obligations defined. For purposes of section 
7701(i)(2)(A)(iii) and this section, payments on asset obligations 
include--
    (i) A payment of principal or interest on an asset obligation, 
including a prepayment of principal, a payment under a credit 
enhancement contract (as defined in paragraph (c)(4)(ii) of this 
section) and a payment from a settlement at a discount (other than a 
substantial discount);
    (ii) A payment from a settlement at a substantial discount, but 
only if the settlement is arranged, whether in writing or otherwise, 
prior to the issuance of the liability obligations; and
    (iii) A payment from the foreclosure on or sale of an asset 
obligation, but only if the foreclosure or sale is arranged, whether in 
writing or otherwise, prior to the issuance of the liability 
obligations.
    (3) Safe harbor for entities formed to liquidate assets. Payments 
on liability obligations of an entity do not bear a relationship to 
payments on asset obligations of the entity if--
    (i) The entity's organizational documents manifest clearly that the 
entity is formed for the primary purpose of liquidating its assets and 
distributing proceeds of liquidation;
    (ii) The entity's activities are all reasonably necessary to and 
consistent with the accomplishment of liquidating assets;
    (iii) The entity plans to satisfy at least 50 percent of the total 
issue price of each of its liability obligations having a different 
maturity with proceeds from liquidation and not with scheduled payments 
on its asset obligations; and
    (iv) The terms of the entity's liability obligations (or underlying 
arrangement) provide that within three years of the time it first 
acquires assets to be liquidated the entity either--
    (A) Liquidates; or
    (B) Begins to pass through without delay all payments it receives 
on its asset obligations (less reasonable allowances for expenses) as 
principal payments on its liability obligations in proportion to the 
adjusted issue prices of the liability obligations.
    (g) Anti-avoidance rules--(1) In general. For purposes of 
determining whether an entity meets the definition of a taxable 
mortgage pool, the Commissioner can disregard or make other adjustments 
to a transaction (or series of transactions) if the transaction (or 
series) is entered into with a view to achieving the same economic 
effect as that of an arrangement subject to section 7701(i) while 
avoiding the application of that section. The Commissioner's authority 
includes treating equity interests issued by a non-REMIC as debt if the 
entity issues equity interests that correspond to maturity classes of 
debt.
    (2) Certain investment trusts. Notwithstanding paragraph (g)(1) of 
this section, an ownership interest in an entity that is classified as 
a trust under Sec. 301.7701-4(c) will not be treated as a debt 
obligation of the trust.
    (3) Examples. The following examples illustrate the principles of 
this paragraph (g):

    Example 1. (i) Partnership P, in addition to its other 
investments, owns $10,000,000 of mortgage pass-through certificates 
guaranteed by FNMA (FNMA Certificates). On May 15, 1997, Partnership 
P transfers the FNMA Certificates to Trust 1 in exchange for 100 
Class A bonds and Certificate 1. The Class A bonds, under which 
Trust 1 is the obligor, have a stated principal amount of $5,000,000 
and bear a relationship to the FNMA Certificates (within the meaning 
of Sec. 301.7701(i)-1(f)). Certificate 1 represents the residual 
beneficial ownership of the FNMA Certificates.
    (ii) On July 5, 1997, with a view to avoiding the application of 
section 7701(i), Partnership P transfers Certificate 1 to Trust 2 in 
exchange for 100 Class B bonds and Certificate 2. The Class B bonds, 
under which 

[[Page 40091]]
Trust 2 is the obligor, have a stated principal amount of $5,000,000, 
bear a relationship to the FNMA Certificates (within the meaning of 
Sec. 301.7701(i)-1(f)), and have a different maturity than the Class 
A bonds (within the meaning of Sec. 301.7701(i)-1(e)). Certificate 2 
represents the residual beneficial ownership of Certificate 1.
    (iii) For purposes of determining whether Trust 1 is classified 
as a taxable mortgage pool, the Commissioner can disregard the 
separate existence of Trust 2 and treat Trust 1 and Trust 2 as a 
single trust.
    Example 2. (i) Corporation Q files a consolidated return with 
its two wholly-owned subsidiaries, Corporation R and Corporation S. 
Corporation R is in the business of building and selling single 
family homes. Corporation S is in the business of financing sales of 
those homes.
    (ii) On August 10, 1998, Corporation S transfers a pool of its 
real estate mortgages to Trust 3, taking back Certificate 3 which 
represents beneficial ownership of the pool. On September 25, 1998, 
with a view to avoiding the application of section 7701(i), 
Corporation R issues bonds that have different maturities (within 
the meaning of Sec. 301.7701(i)-1(e)) and that bear a relationship 
(within the meaning of Sec. 301.7701(i)-1(f)) to the real estate 
mortgages in Trust 3. The holders of the bonds have an interest in a 
credit enhancement contract that is written by Corporation S and 
collateralized with Certificate 3.
    (iii) For purposes of determining whether Trust 3 is classified 
as a taxable mortgage pool, the Commissioner can treat Trust 3 as 
the obligor of the bonds issued by Corporation R.
    Example 3. (i) Corporation X, in addition to its other assets, 
owns $110,000,000 in Treasury securities. From time to time, 
Corporation X acquires pools of real estate mortgages, which it 
immediately uses to issue multiple-class debt obligations.
    (ii) On October 1, 1996, Corporation X transfers $20,000,000 in 
Treasury securities to Trust 4 in exchange for Class C bonds, Class 
D bonds, Class E bonds, and Certificate 4. Trust 4 is the obligor of 
the bonds. The different classes of bonds have the same stated 
maturity date, but if cash flows from the Trust 4 assets exceed the 
amounts needed to make interest payments, the trustee uses the 
excess to retire the classes of bonds in alphabetical order. 
Certificate 4 represents the residual beneficial ownership of the 
Treasury securities.
    (iii) With a view to avoiding the application of section 
7701(i), Corporation X reserves the right to replace any Trust 4 
asset with real estate mortgages or guaranteed mortgage pass-through 
certificates. In the event the right is exercised, cash flows on the 
real estate mortgages and guaranteed pass-through certificates will 
be used in the same manner as cash flows on the Treasury securities. 
Corporation X exercises this right of replacement on February 1, 
1997.
    (iv) For purposes of determining whether Trust 4 is classified 
as a taxable mortgage pool, the Commissioner can treat February 1, 
1997, as a testing day (within the meaning of Sec. 301.7701(i)-
3(c)(2)). The result is the same if Corporation X has an obligation, 
rather than a right, to replace the Trust 4 assets with real estate 
mortgages and guaranteed pass-through certificates.
    Example 4. (i) Corporation Y, in addition to its other assets, 
owns $1,900,000 in obligations secured by personal property. On 
November 1, 1995, Corporation Y begins negotiating a $2,000,000 loan 
to individual A. As security for the loan, A offers a first deed of 
trust on land worth $1,700,000.
    (ii) With a view to avoiding the application of section 7701(i), 
Corporation Y induces A to place the land in a partnership in which 
A will have a 95 percent interest and agrees to accept the 
partnership interest as security for the $2,000,000 loan. 
Thereafter, the loan to A, together with the $1,900,000 in 
obligations secured by personal property, are transferred to Trust 5 
and used to issue bonds that have different maturities (within the 
meaning of Sec. 301.7701(i)-1(e)) and that bear a relationship 
(within the meaning of Sec. 301.7701(i)-1(f)) to the $1,900,000 in 
obligations secured by personal property and the loan to A.
    (iii) For purposes of determining whether Trust 5 is a taxable 
mortgage pool, the Commissioner can treat the loan to A as an 
obligation secured by an interest in real property rather than as an 
obligation secured by an interest in a partnership.
    Example 5. (i) Corporation Z, in addition to its other assets, 
owns $3,000,000 in notes secured by interests in retail shopping 
centers. Partnership L, in addition to its other assets, owns 
$20,000,000 in notes that are principally secured by interests in 
single family homes and $3,500,000 in notes that are principally 
secured by interests in personal property.
    (ii) On December 1, 1995, Partnership L asks Corporation Z for 
two separate loans, one in the amount of $9,375,000 and another in 
the amount of $625,000. Partnership L offers to collateralize the 
$9,375,000 loan with $10,312,500 of notes secured by interests in 
single family homes and the $625,000 loan with $750,000 of notes 
secured by interests in personal property. Corporation Z has made 
similar loans to Partnership L in the past.
    (iii) With a view to avoiding the application of section 
7701(i), Corporation Z induces Partnership L to accept a single 
$10,000,000 loan and to post as collateral $7,500,000 of the notes 
secured by interests in single family homes and all $3,500,000 of 
the notes secured by interests in personal property. Ordinarily, 
Corporation Z would not make a loan on these terms. Thereafter, the 
loan to Partnership L, together with the $3,000,000 in notes secured 
by interests in retail shopping centers, are transferred to Trust 6 
and used to issue bonds that have different maturities (within the 
meaning of Sec. 301.7701(i)-1(e)) and that bear a relationship 
(within the meaning of Sec. 301.7701(i)-1(f)) to the loans secured 
by interests in retail shopping centers and the loan to Partnership 
L.
    (iv) For purposes of determining whether Trust 6 is a taxable 
mortgage pool, the Commissioner can treat the $10,000,000 loan to 
Partnership L as consisting of a $9,375,000 obligation secured by 
interests in real property and a $625,000 obligation secured by 
interests in personal property. Under Sec. 301.7701(i)-
1(d)(3)(ii)(A), the notes secured by single family homes are treated 
as $7,500,000 of interests in real property. Under Sec. 301.7701(i)-
1(d)(3)(i)(A), $7,500,000 of interests in real property are 
sufficient to treat the $9,375,000 obligation as principally secured 
by an interest in real property ($7,500,000 equals 80 percent of 
$9,375,000).


Sec. 301.7701(i)-2  Special rules for portions of entities.

    (a) Portion defined. Except as provided in paragraph (b) of this 
section and Sec. 301.7701(i)-1, a portion of an entity includes all 
assets that support one or more of the same issues of debt obligations. 
For this purpose, an asset supports a debt obligation if, under the 
terms of the debt obligation (or underlying arrangement), the timing 
and amount of payments on the debt obligation are in large part 
determined, either directly or indirectly, by the timing and amount of 
payments or projected payments on the asset or a group of assets that 
includes the asset. Indirect payment arrangements include, for example, 
a swap or other hedge, or arrangements where the timing and amount of 
payments on the debt obligations are determined by reference to a group 
of assets (or an index or other type of model) that has an expected 
payment experience similar to that of the assets. For purposes of this 
paragraph, the term payments includes all proceeds and receipts from an 
asset.
    (b) Certain assets and rights to assets disregarded--(1) Credit 
enhancement assets. An asset that qualifies as a credit enhancement 
contract (as defined in Sec. 301.7701(i)-1(c)(4)(ii)) is not included 
in a portion as a separate asset, but is treated as part of the assets 
in the portion to which it relates under Sec. 301.7701(i)-1(c)(4)(i). 
An asset that does not qualify as a credit enhancement contract (as 
defined in Sec. 301.7701(i)-1(c)(4)(ii)), but that nevertheless serves 
the same function as a credit enhancement contract, is not included in 
a portion as a separate asset or otherwise.
    (2) Assets unlikely to service obligations. A portion does not 
include assets that are unlikely to produce any significant cash flows 
for the holders of the debt obligations. This paragraph applies even if 
the holders of the debt obligations are legally entitled to cash flows 
from the assets. Thus, for example, even if the sale of a building 
would cause a series of debt obligations to be redeemed, the building 
is not included in a portion if it is not likely to be sold.
    (3) Recourse. An asset is not included in a portion solely because 
the holders 

[[Page 40092]]
of the debt obligations have recourse to the holder of that asset.
    (c) Portion as obligor--(1) In general. For purposes of section 
7701(i)(2)(A)(ii), a portion of an entity is treated as the obligor of 
all debt obligations supported by the assets in that portion.
    (2) Example. The following example illustrates the principles of 
this section:

    Example. (i) Corporation Z owns $1,000,000,000 in assets 
including an office complex and $90,000,000 of real estate 
mortgages.
    (ii) On November 30, 1998, Corporation Z issues eight classes of 
bonds, Class A through Class H. Each class is secured by a separate 
letter of credit and by a lien on the office complex. One group of 
the real estate mortgages supports Class A through Class D, another 
group supports Class E through Class G, and a third group supports 
Class H. It is anticipated that the cash flows from each group of 
mortgages will service its related bonds.
    (iii) Each of the following constitutes a separate portion of 
Corporation Z: the group of mortgages supporting Class A through 
Class D; the group of mortgages supporting Class E through Class G; 
and the group of mortgages supporting Class H. No other asset is 
included in any of the three portions notwithstanding the lien of 
the bonds on the office complex and the fact that Corporation Z is 
the issuer of the bonds. The letters of credit are treated as 
incidents of the mortgages to which they relate.
    (iv) For purposes of section 7701(i)(2)(A)(ii), each portion 
described above is treated as the obligor of the bonds of that 
portion, notwithstanding the fact that Corporation Z is the legal 
obligor with respect to the bonds.


Sec. 301.7701(i)-3  Effective dates and duration of taxable mortgage 
pool classification.

    (a) Effective dates. Except as otherwise provided, the regulations 
under section 7701(i) are effective and applicable September 6, 1995.
    (b) Entities in existence on December 31, 1991--(1) In general. For 
transitional rules concerning the application of section 7701(i) to 
entities in existence on December 31, 1991, see section 675(c) of the 
Tax Reform Act of 1986.
    (2) Special rule for certain transfers. A transfer made to an 
entity on or after September 6, 1995, is a substantial transfer for 
purposes of section 675(c)(2) of the Tax Reform Act of 1986 only if--
    (i) The transfer is significant in amount; and
    (ii) The transfer is connected to the entity's issuance of related 
debt obligations (as defined in paragraph (b)(3) of this section) that 
have different maturities (within the meaning of Sec. 301.7701-1(e)).
    (3) Related debt obligation. A related debt obligation is a debt 
obligation whose payments bear a relationship (within the meaning of 
Sec. 301.7701-1(f)) to payments on debt obligations that the entity 
holds as assets.
    (4) Example. The following example illustrates the principles of 
this paragraph (b):

    Example. On December 31, 1991, Partnership Q holds a pool of 
real estate mortgages that it acquired through retail sales of 
single family homes. Partnership Q raises $10,000,000 on October 25, 
1996, by using this pool to issue related debt obligations with 
multiple maturities. The transfer of the $10,000,000 to Partnership 
Q is a substantial transfer (within the meaning of Sec. 301.7701(i)-
3(b)(2)).

    (c) Duration of taxable mortgage pool classification--(1) 
Commencement and duration. An entity is classified as a taxable 
mortgage pool on the first testing day that it meets the definition of 
a taxable mortgage pool. Once an entity is classified as a taxable 
mortgage pool, that classification continues through the day the entity 
retires its last related debt obligation.
    (2) Testing day defined. A testing day is any day on or after 
September 6, 1995, on which an entity issues a related debt obligation 
(as defined in paragraph (b)(3) of this section) that is significant in 
amount.


Sec. 301.7701(i)-4  Special rules for certain entities.

    (a) States and municipalities--(1) In general. Regardless of 
whether an entity satisfies any of the requirements of section 
7701(i)(2)(A), an entity is not classified as a taxable mortgage pool 
if--
    (i) The entity is a State, territory, a possession of the United 
States, the District of Columbia, or any political subdivision thereof 
(within the meaning of Sec. 1.103-1(b) of this chapter), or is 
empowered to issue obligations on behalf of one of the foregoing;
    (ii) The entity issues the debt obligations in the performance of a 
governmental purpose; and
    (iii) The entity holds the remaining interests in all assets that 
support those debt obligations until the debt obligations issued by the 
entity are retired.
    (2) Governmental purpose. The term governmental purpose means an 
essential governmental function within the meaning of section 115. A 
governmental purpose does not include the mere packaging of debt 
obligations for re-sale on the secondary market even if any profits 
from the sale are used in the performance of an essential governmental 
function.
    (3) Determinations by the Commissioner. If an entity is not 
described in paragraph (a)(1) of this section, but has a similar 
purpose, then the Commissioner may determine that the entity is not 
classified as a taxable mortgage pool.
    (b) REITs. [Reserved]
    (c) Subchapter S corporations--(1) In general. An entity that is 
classified as a taxable mortgage pool may not elect to be an S 
corporation under section 1362(a) or maintain S corporation status.
    (2) Portion of an S corporation treated as a separate corporation. 
An S corporation is not treated as a member of an affiliated group 
under section 1361(b)(2)(A) solely because a portion of the S 
corporation is treated as a separate corporation under section 7701(i).

Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: July 17, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-19285 Filed 8-4-95; 8:45 am]
BILLING CODE 4830-01-U